Clamping down – on the Bank of England’s stress test

Nathan Coombs

After the announcement that the Royal Bank of Scotland failed the Bank of England’s latest stress test, the UK’s Channel 4 News reported the story by showing RBS’s logo crumbling under the weight of a pile of concrete bricks. The image is appropriate. Since coming into public ownership eight years ago, there have been persistent concerns that RBS might not prove resilient to a further economic shock. The recent stress test showed that these fears are perhaps well-founded.

The test showed that in the event of a particularly severe synchronised UK and global recession (as well as shocks to financial markets and bank misconduct losses) RBS would barely scrape past its 6.6% capital ratio pass rate. Worse still, RBS failed to meet the minimum leverage ratio of 3%. The bank would have to raise an extra £2 billion to satisfy the regulators.

Barclays and Standard Chartered also fared poorly. While Barclays’s capital and leverage ratios passed the test, it missed its ‘systemic reference point’ before additional tier 1 instruments converted (bonds that turn into common equity if a bank’s capital falls below a certain point). Standard Chartered did better, but it was let down by its tier 1 capital ratio coming up short (a ratio that factors in other instruments in addition to common equity and retained earnings).

These are the headline figures the media focused on. Their meaning is difficult to interpret in an absolute sense, but they give an indicator of the relative resilience of the different UK banks and their specific points of fragility. Take a look at what the report has to say about the UK’s banking sector as a whole, however, and its most critical remarks are reserved for its ‘qualitative review’. Couched in the careful language of the financial policy world, the report states that although progress has been made across the sector the Bank is ‘disappointed that the rate of improvement has been slower and more uneven than expected’.

What does this refer to? The qualitative aspects of stress testing have received less attention than they probably deserve to. In a recent speech, a governor of the US Federal Reserve, Daniel Tarullo, even complained that they are ‘frequently overlooked’, despite both banks who failed the Fed’s 2016 exercise (Deutsche Bank and Santander) doing so on qualitative grounds.

The qualitative aspects of stress testing vary across jurisdictions, but in the UK they focus on how banks derive their figures. Just like in a maths exam, it’s nowadays not enough for banks to arrive at the right number; regulators want explanations of their assumptions and justifications for their choice of models. Additional qualitative reporting obligations include the need for a detailed narrative about banks’ risk governance, capital planning processes and how they ‘review and challenge’ their models.

These qualitative reports might seem like inconsequential back-office documentation. But they are increasingly at the heart of what the stress tests are trying to achieve. The popular image of stress testing is that of the heroic technocratic venture lionised in Timothy Geithner’s 2014 memoir, Stress Test. Through the collection of vast amounts of data and the application of sophisticated quantitative tools, the regulator pierces through the epistemic fog and gets to the ‘true’ state of a bank’s balance sheet.

While that might describe the tests conducted by central banks during the financial crisis, in the years since the tests have served the additional, more subtle, purpose of attempting to change financial culture. As Gillian Tett writes in her latest book, The Silo Effect, one important cause for the financial crisis was excessive organizational complexity and a lack of joined-up thinking. Risks that should have been spotted by banks were obscured by divisional ‘silos’ impeding the free-flow of knowledge. The people who should have been talking to one another weren’t.

For this reason, the additional information the Bank of England’s report provides on their forthcoming ‘exploratory’ scenario in 2017 is noteworthy. This new biennial test will run alongside the standard test next year and has been the subject of much speculation since it was first announced in 2015. In the financial community it was widely expected to involve a historically-unprecedented or exceptionally severe scenario that would push banks modelling practices – and capital reserves – to their limit.

The report has confounded those expectations. Emphasising that the data collected from the banks will be ‘significantly less detailed’ than that in the regular stress test, the 2017 exploratory scenario will take place over an extended seven year time horizon and will test banks’ business models in light of expected competitive pressures from ‘smaller banks and non-bank businesses’. Already, the stress testing managers of UK banks are probably scratching their heads and consulting with colleagues about how they’re supposed to model that. That’s the point.